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How This Small-Cap Tech ETF Topped Its Larger Rivals

Sometimes, thinking small gives you big growth.

Innovation is the name of the game for investors seeking the best technology stocks, and the earlier you find a successful tech company, the bigger your long-term returns will be. Many of the top ETFs in the technology space focus on large-cap industry behemoths that are already household names around the world. However, one exchange-traded fund concentrates specifically on small-cap tech stocks, and it has outperformed both the broader market and most of its sector peers. As you can see below, looking at smaller companies can help you find the information technology leaders of tomorrow at a time when they'll do your portfolio the most good.

Drilling down on small-cap tech

The PowerShares small-cap tech ETF aims to track the performance of those members of the S&P SmallCap 600 index that are in the information technology arena. About half of the ETF's portfolio is split between the electronic equipment and components industry and the semiconductor and semiconductor equipment industry. Software, communications equipment, and IT services add up to another 35% of assets, with the remainder going to internet software and services and technology hardware, storage, and peripherals.

Small-cap stocks make up all but one or two of the fund's holdings, showing discipline in selling winners that graduate to mid-cap or large-cap status. Growth is a clear priority among these companies, with only 8% of holdings considered value stocks compared to 56% as pure growth and 36% as a mix.

The success of technology stocks generally shows through in the PowerShares ETF's performance. With average annual returns that are more than 3.5 percentage points higher than the already impressive gains for the large-cap focused SPDR Technology ETF, small-cap stocks have delivered on the idea that being willing to take greater risks for greater reward can pay off.

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What you'll find among small-cap tech's winners

A look at some of the PowerShares ETF's holdings demonstrates just how obscure some of these companies are. MKS Instruments (NASDAQ:MKSI) has created systems, instruments, and controllers that help its clients monitor, analyze, and control manufacturing processes. The stock has more than doubled since early 2016, as its customer base has benefited from an uptick in prospects for industries like semiconductors, lasers, and medical equipment.

3-D sensing technology playerLumentum Holdings (NASDAQ:LITE) has gotten a bit more attention from investors, largely because they hope that Lumentum can capitalize on future demand for more efficient sensors for applications in everything from manufacturing processes to virtual reality. At the same time, makers of fiber-optic cable have soared on expectations that future upgrades to 5G wireless service will require dramatic expansion of existing wireless infrastructure assets. The stock has more than tripled since early 2016 in response to improving industry conditions.

Because of their size, these companies escape the notice of many investors. That's how ETFs can be helpful, because they automatically include stocks soon after those stocks gain eligibility for the index the ETFs track.

Going part of the way

Many investors find small-cap stocks to be too risky, especially in volatile areas like technology. One alternative is to stick with an ETF geared toward larger companies but with a strategy that emphasizes up-and-coming players in the space.

The Guggenheim tech ETF shows one approach. The equal-weighted ETF has the same huge tech companies as the SPDR ETF, but it doesn't share the SPDR's overweight positions in those companies. The result is a more than 40% exposure to mid-cap tech stocks, and much of the remainder goes toward stocks at the lower end of the large-cap spectrum. Only 16% of the ETF is invested in industry giants, compared to nearly 70% for the SPDR. The approach boosts returns dramatically, taking advantage of the fact that the largest companies in the industry have a hard time producing the same percentage returns as smaller counterparts.

Get strong returns from tech stocks

Large-cap stocks appeal to many investors because they've already proven their success. If you want the best returns available, though, small-cap stocks are where you need to look, especially in the technology industry. Finding tomorrow's game-changers today can add a big boost to your portfolio returns.

Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

Author

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.
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